Continued weakness in bank lending puts further pressure on the ECB

The money supply in the euro area weakened further in April and the annual growth rate in broad money M3 declined to 0.8% y/y from 1.0% in March. This is far below the ECB’s old reference rate of 4.5%. M1 growth declined to 5.2% y/y in April from 5.6% in March. M1 growth has been a good leading indicator for GDP growth and the real rate still points to a pick-up in growth on a nine-month horizon.

Loans to the private sector adjusted for loan sales and securitisation continued to decline but at a slower pace. In April it declined 1.5% y/y after having declined 2.0% for fourth consecutive months. Loans to non-financial corporations (NFCs) remained very low and declined 2.7% y/y. The monthly loan flow showed a decline of EUR4bn, slightly down from a decline of EUR3bn in March. The monthly flow to NFCs has been negative since July 2012. Loans to households increased 0.4% for the third consecutive month and the monthly flow showed a small increase of EUR3bn.

The ECB’s growth projection made in March was based on gradually improving credit supply conditions but the continued weakness in bank lending should affect the ECB’s growth forecast. The ECB has for a long time argued there is a lagged relationship between credit flows and the business cycle’s recovery but this week Draghi held a speech at the ECB’s forum on central banking un which he emphasised the problem of weak credit growth and argued that it added to the disinflationary pressure in the periphery countries. He also explained that up to a third of the economic slack in the stressed countries is due to credit weakness.

Given Draghi’s increased focus on credit, we think the probability of a bank lending measure has increased. It also seems more likely that it comes before the Asset Quality Review and the stress tests are completed in Q4. This followed as Draghi said credit demand might pick up and if this happens and there are binding constraints on credit supply, the monetary policy would not produce its full effect.

In our view, the ECB’s preferred bank lending instrument will be a targeted LTRO. The ECB is likely to be inspired by the Bank of England’s Funding for Lending scheme. However, the choice of bank lending instrument will depend on the ECB’s judgement of whether lack of credit supply is due to under capitalisation of banks. If this is the case, a targeted LTRO is less effective as it does not remove loans from banks’ balance sheets. Related to that, Draghi’s speech on Monday indicated that the ECB sees advantages in ABS purchases due to its off-balance structure. On the other hand, an ABS programme leaves the ECB with a great credit risk and this might be a hurdle.